Markets & Finance

The Stock Market's Surprising Strength

Even after many observers said equities had rallied too far, too fast, major indexes continue to hit new highs for the year. Can the market keep it up?

U.S. stocks again hit a new high for the year on June 11, surprising doubters who had insisted the markets' explosive rally since March would be reversed.

The Standard & Poor's 500-stock index, at 944.89, is now up almost 40% since its decade-old low on Mar. 9. The broad index is up 4.6% in 2009. (However, that barely dents the S&P 500's 38% loss in 2008, when the S&P 500 started the year at 1,468.) "This market has a propensity to surprise. It's proven that," says Michael Church, president of Addison Capital Management.

For skeptics, the recent rally is a challenge: After a rough 2008, investment managers do not want to be left behind, Church says. "People are saying, 'I've got to do something,' " he says.

Mixed Economic Data

But what to do? The economy remains shaky. And even optimists, hoping for a recovery later this year, warn of big economic challenges ahead. "It's harder to be bullish than bearish," says Rob Lutts, founder of Cabot Money Management. Nonetheless, he adds, "I'm bullish—and nervous."

Recent economic data demonstrate the mixed picture for equity investors. Retail sales rose by 0.5% in May, more than expected and after two months when sales fell. Unfortunately, most of this rise was due to climbing gas prices.

Lombard Street Research notes the average price of gasoline rose 23% from Apr. 27 to June 1, from $2.05 to $2.52 per gallon. "A large chunk of U.S. household spending has thus been diverted into paying for gasoline," says Lombard's Gabriel Stein.

Some evidence suggests job losses are slowing. Initial jobless claims were 601,000 last week, the lowest since Jan. 24. The four-week average, 621,750, was the lowest since Feb. 14.

However, more Americans continue to get unemployment benefits than ever, a record 6.8 million at the end of May. U.S. home foreclosures may have slowed last month, but only after a record high of 342,000 in April. Foreclosure activity fell 6% in May, according to RealtyTrac. It remains 18% above May 2008 levels.

Moreover, some suggest, the market's momentum might not only reflect the economy's recovery but actually encourage it.

Rates on Treasuries are rising—causing some to worry higher interest rates could choke off a recovery—but overall credit markets are showing signs of returning health. "That's a very favorable and self-reinforcing sign," says Jerry Webman, chief economist at OppenheimerFunds. If companies can get credit again, they can grow or at least survive. If investors are willing to put money in riskier assets, it also shows they're less skittish than at the depths of the financial crisis.

Though interest rates have risen, they've moved into "more normal" territory, Lutt says. "That's really an indication of an improving economy."

The spike in gas, oil, and other commodity prices has worried some economists. But it's also a sign of strength. "As long as energy prices don't get too out of hand, that's a good sign," says Peter Cardillo, chief market economist at Avalon Partners. "That's a sign that demand is probably rising, [that] the global economy is pulling out of recession."

Addison's Church says he doubts the economy is "fully out of the woods." But the market's vitality could lift spirits. "This market now can lead the economy," he says. "This could be self-fulfilling."

Consumers Still Cautious

Unfortunately, beyond this improvement in mood, the economy has few other hopes for a strong recovery. The housing market is likely to remain disappointing, Church says.

Don't expect cash-strapped consumers to flock back to the malls. "As long as you have high unemployment, consumers are going to be very frugal," Cardillo says.

For three months, the stock market has steadily moved higher. But in the future, don't expect either the economy or the stock market to show such consistency.

Certain factors, like the threat of higher interest rates or commodity prices, limit how fast this economy can recover, Webman says. "It's a little bit like driving in New York or Los Angeles traffic," he adds. "You speed up and slow down, but eventually you get there."

The big question for investors, then, is how many months, or years, this trip to recovery lasts.